An Application of CDS-Implied Ratings to Synthetic CDOs
Posted: 11 Feb 2008
Date Written: February 2008
Recent volatility in structured credit markets has focused attention to the need for market-based measures of credit risk for structured credit products. Unlike in the single-name market, structured credit investors have heretofore had no alternatives to traditional credit ratings to measure the risks of CDO liabilities. In this ViewPoints piece we demonstrate how Moody's CDS-implied ratings for corporate reference names, together with an analytic CDO ratings model (CDOROM), can be used to derive CDS-implied tranche ratings for CDOs. Specifically, our analysis is a case study of a hypothetical synthetic CDO consisting of the 30 reference names in the CDX.NA.IG.HVOL series 3 index. Initial differences between CDO tranche ratings based on Moody's corporate ratings and CDS-implied ratings (the ratings gap) are large. Tranche ratings derived using CDS-implied ratings for the assets are 2 to 5 rating notches lower than those based on Moody's corporate ratings, depending on the level of subordination. Over time, ratings gaps are closed by the Moody's tranche ratings converging toward the CDS-implied tranche ratings. Despite the fact that the underlying Moody's corporate ratings generally exhibit much more stability than CDS-implied ratings, the CDS-implied tranche ratings in our case study are relatively more stable than those based on Moody's ratings. This appears to be because the CDS-implied ratings had already adjusted to a level reflecting the market's relatively dimmer view on the credit quality of some of the reference names (e.g., Delphi, Ford Motor Credit, GMAC) at the time the portfolio of reference entities was created.
Keywords: CDS, CDO, CDX, credit ratings, structured finance
JEL Classification: G10
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